Law, Business and Society 11th Edition by Tony McAdams

Exercise 19

Capital Structure
Businesses often need access to capital to finance their activities. Capital is of two types: debt and equity-two ends of the spectrum with a boundary that can be challenging to identify. The providers of both debt and equity capital hold claims against the corporation's assets. However, creditors' claims are always satisfied before equity holders' claims.
Equity capital (stock) has a long-term horizon. Although any given shareholder may intend to hold the stock for only a short period, the stock itself is generally expected to exist for the full life of the corporation. Three property rights are associated with stock ownership: the right to participate in earnings (that is, dividends), the right to participate in assets upon liquidation, and the right to participate in control. There are two principal classes of stock: preferred and common. Where only one class exists, it is common stock. Common stockholders share all three property rights in proportion to their holdings.
Institutional investors hold 73 percent of the largest 1000 US corporations' stock.
Preferred stock was created, largely for institutional investors, (in 2009 institutional investors owned 73 percent of the largest 1000 US companies) like pension funds, to fill the gap on the risk-return spectrum between long-term debt and common stock. Finance professionals find it advantageous to have many different ways to combine risk and return. Preferred stock is associated with "preferences," which relate to distributions. Preferred stockholders are paid their required annual dividend in full before any dividends are distributed to the common stockholders. In addition, preferred stockholders have a preference upon the corporation's liquidation. After the creditors are satisfied, the preferred stockholders receive the next round of distributions up to their stock's liquidation value (also called redemption value )-typically a few percent over the stock's par value.
The cost of these two preferences is the loss of the right to participate in control. Having no vote, preferred stockholders cannot elect directors to protect their interests. To help ensure that its holders regularly receive dividends, nearly all preferred stock is cumulative. This means that if a preferred stock dividend is missed, then before the common stockholders get any dividends, the preferred stock arrearage (all dividends not paid in any prior year) must be made up. Another protection occasionally granted to preferred stockholders is a contingent right to vote if, for example, a dividend is missed twice. This voting power would continue until all arrearages have been satisfied.
Because preferred stockholders never get more than their required dividends and, upon liquidation, little more than the purchase price, all corporate growth inures to the common stockholders. If both you and Bill Gates had invested $1 million in Microsoft at the outset, you taking preferred stock and Gates taking common stock, your stock would still be worth about $1 million, whereas Gates's stock would be worth tens of billions.
Debt capital may be short- or long-term. Companies that provide motherboards to Dell are a source of short-term debt capital. They expect to be paid fairly quickly, although not at the moment of delivery. They have extended to Dell a very short-term form of debt. The long-term debt of a closely held corporation is likely to come from a commercial lender who takes a security interest in specified property of the corporation. This is much like an individual who takes out a mortgage from a bank secured by the home the individual purchases with the borrowed funds. Large corporations have another alternative for obtaining long-term debt capital. Just as a public corporation may sell its stock to the public, large corporations may sell units of debt, called bonds, to the public. A pension plan that holds Dell's 20-year bonds is providing long-term debt capital to Dell.
Most debt capital specifies an interest rate (or a formula for computing the interest rate) to be paid on the principal borrowed, both of which (principal and interest) are required to be paid in set amounts, usually over a defined term.
Corporations carefully manage their capital structures (the balance between debt and equity). If the debt/equity ratio is too high, the corporation may be exposed to severe risk because debt obligations must be timely paid without regard to how profitable the business operations are. Further, the capital structure must be managed to ensure that debt covenants are not breached. A debt covenant is a term in the lending contract that makes the debt immediately payable should the condition specified not be satisfied (such as exceeding a specified debt/equity ratio). On the other hand, if the ratio is too low, opportunities for positive financial leverage (employing funds at a rate of return that exceeds the interest rate on the borrowed funds) may be forfeited. Executives also recognize that interest paid on debt is tax deductible, whereas dividends paid to shareholders are not. This places a strong emphasis on the use of debt capital.
If you compare the characteristics of debt capital with preferred and common stock, you can readily see that preferred stock indeed does bridge the gap between common stock and debt. Increasingly, preferred stock is being issued with more debtlike characteristics. This poses serious classification problems for accountants, tax authorities, and bankruptcy courts.
a. What property rights are associated with common stock
b. Does preferred stock have all of these rights